R 5
Elasticity and its
Application
Microeonomics
PRINCIPLES OF
N. Gregory
Mankiw
Premium PowerPoint Slides
by Ron Cronovich
2009 South-Western, a part of Cengage Learning, all rights reserved
In this chapter,
look for the answers to these
questions:
What is elasticity? What kinds of issues can
elasticity help us understand?
What is the price elasticity of demand?
How is it related to the demand curve?
How is it related to revenue & expenditure?
What is the price elasticity of supply?
How is it related to the supply curve?
What are the income and cross-price elasticities of
demand?
2
A scenario
You
You design
design websites
websites forfor local
local businesses.
businesses.
You
You charge
charge 12000
12000 per per website,
website,
and
and currently
currently sell
sell 12
12 websites
websites per per month.
month.
Your
Your costs
costs are
are rising
rising
(including
(including the
the opportunity
opportunity cost cost of
of your
your time),
time),
so
so you
you consider
consider raising
raising thethe price
price toto 15000.
15000.
The
The law
law of
of demand
demand says says thatthat you
you wont
wont sell
sell as
as
many
many websites
websites ifif you
you raise
raise your
your price.
price.
How
How many
many fewer
fewer websites?
websites? How How much
much will
will your
your
revenue
revenue fall,
fall, or
or might
might itit increase?
increase?
3
Elasticity
Basic idea:
Elasticity measures how much one variable
responds to changes in another variable.
One type of elasticity measures how much
demand for your websites will fall if you raise
your price.
Definition:
Elasticity is a numerical measure of the
responsiveness of Qd or Qs to one of its
determinants.
12
ACTIVE LEARNING 1
Answers
Use midpoint method to calculate
% change in Qd
(5000 3000)/4000 = 50%
% change in P
(900 700)/800 = 25%
The price elasticity of demand equals
50%
= 2.0
25%
13
What determines price
elasticity?
To learn the determinants of price elasticity,
we look at a series of examples.
Each compares two common goods.
In each example:
Suppose the prices of both goods rise by 20%.
The good for which Qd falls the most (in percent)
has the highest price elasticity of demand.
Which good is it? Why?
What lesson does the example teach us about the
determinants of the price elasticity of demand?
P falls Q
Elasticity: by 10% Q1 Q2
1
Q rises by 10%
$0 Q
0 20 40 60
Revenue = P x Q
If demand is elastic, then
price elast. of demand > 1
% change in Q > % change in P
The fall in revenue from lower Q is greater
than the increase in revenue from higher P,
so revenue falls.
ELASTICITY AND ITS APPLICATION 30
Price Elasticity and Total
Revenue
Elastic demand increased
Demand
revenue
(elasticity = 1.8) P due to
for your
websites
higher P
If P = 12000, lost
revenue
Q = 12 and 15000 due to
lower Q
revenue = 1,44000.
12000
If P = 15000, D
Q = 8 and
revenue = 120000.
When D is elastic, Q
8 12
a price increase
causes revenue to fall.
ELASTICITY AND ITS APPLICATION 31
Price Elasticity and Total
Revenue
Price elasticity Percentage change in Q
=
of demand Percentage change in P
Revenue = P x Q
If demand is inelastic, then
price elast. of demand < 1
% change in Q < % change in P
The fall in revenue from lower Q is smaller
than the increase in revenue from higher P,
so revenue rises.
In our example, suppose that Q only falls to 10
(instead of 8) when you raise your price to 15000.
ELASTICITY AND ITS APPLICATION 32
Price Elasticity and Total
Revenue
Now, demand is increased revenue
less elastic: due to higher P
elasticity = 0.82 P
Demand for
your websites
If P = 12000,
Q = 12 and revenue =
lost revenue
144000. 15000 due to lower Q
12000
If P = 15000,
Q = 10 and
D
revenue = 150000.
When D is inelastic,
Q
a price increase 10 12
causes revenue to rise.
ELASTICITY AND ITS APPLICATION 33
ACTIVE LEARNING 2
Elasticity and
expenditure/revenue
A. Pharmacies raise the price of insulin by 10%.
Does total expenditure on insulin rise or fall?
B. As a result of a fare war, the price of a luxury
cruise falls 20%.
Does luxury cruise companies total revenue
rise or fall?
34
ACTIVE LEARNING 2
Answers
A. Pharmacies raise the price of insulin by 10%.
Does total expenditure on insulin rise or fall?
Expenditure = P x Q
Since demand is inelastic, Q will fall less
than 10%, so expenditure rises.
35
ACTIVE LEARNING 2
Answers
B. As a result of a fare war, the price of a luxury
cruise falls 20%.
Does luxury cruise companies total revenue
rise or fall?
Revenue = P x Q
The fall in P reduces revenue,
but Q increases, which increases revenue.
Which effect is bigger?
Since demand is elastic, Q will increase more
than 20%, so revenue rises.
36
APPLICATION: Does Drug Interdiction
Increase or Decrease Drug-Related
Crime?
One side effect of illegal drug use is crime:
Users often turn to crime to finance their habit.
We examine two policies designed to reduce
illegal drug use and see what effects they have
on drug-related crime.
For simplicity, we assume the total dollar value
of drug-related crime equals total expenditure
on drugs.
Demand for illegal drugs is inelastic, due to
addiction issues.
ELASTICITY AND ITS APPLICATION 37
Policy 1: Interdiction
Interdiction new value of drug-
reduces Price of related crime
the supply Drugs S2
D1
of drugs. S1
Since demand P2
for drugs is
inelastic, initial value
P1
P rises propor- of drug-
tionally more related
than Q falls. crime
P and Q fall.
P1 initial value
Result: of drug-
A decrease in P2 related
total spending crime
on drugs, and
in drug-related Q2 Q 1 Quantity
crime. of Drugs
49
ACTIVE LEARNING 3
Answers
Beachfront property
When supply (inelastic supply):
is inelastic, P
an increase in
demand has a D1 D2 S
bigger impact
on price than P2 B
on quantity.
P1 A
Q
Q1 Q2
50
ACTIVE LEARNING 3
Answers
New cars
When supply (elastic supply):
is elastic, P
an increase in
demand has a D1 D2
bigger impact S
on quantity
than on price. B
P2
A
P1
Q
Q1 Q2
51
How the Price Elasticity of Supply
Can Vary
P Supply
Supply often
often
S
elasticity becomes
becomes
15 <1 less
less elastic
elastic
as
as Q
Q rises,
rises,
12 due
due to
to
capacity
capacity
elasticity
>1 limits.
limits.
4
3
Q
100 200
500 525
58